I HOLD THIS TRUTH TO BE SELF-EVIDENT, THAT A DEBT CRISIS CANNOT BE RESOLVED WITH MORE DEBT

Thursday, June 11, 2009

Deflation v. Inflation

The debate rages on in the financial blogosphere: will the current crisis ultimately be resolved through a period of cataclysmic deflation or in a hyper-inflationary auto da fe, Weimar-style? (Typical of human reactions when emotions run high, very few talk about middle-of-the-road alternatives.)

What do I think? First, some background to set the stage.

In the past few decades we experienced rapid asset inflation, combined with relatively mild consumer price inflation. Many perceived this to be a good development - and up to a point it was. After all, who doesn't want to see their wealth increase while paying low prices for goods?

Trouble is, you can't have it both ways for too long because asset prices must reflect a reasonable multiple of the income they produce ("rents"). Income derived from assets must be high enough to provide a competitive current return and to offset the risk of holding them. That is to say, dividends from shares, interest from bonds and rents from real estate must have reasonable yield ratios.

How do we know when assets reach unreasonable levels, i.e. how do we define a bubble? Greenspan claimed that it was impossible to do so and that we could only identify bubbles after they burst. Obviously, I disagree.

Apart from observing crowd psychology (i.e. maniacal behaviour), I believe the best fundamental indicator of a bubble is the relationship between earned income and debt. Don't forget that asset prices and debt levels are opposite sides of the same card: it takes lots of "money" (debt) to inflate asset prices. Debt, on the other hand, must be comfortably serviced out of earned income: wages, salaries, etc. When the two are considerably out of balance then the debt-asset bubble must and will pop.

Furthermore, things get really ugly when debt and asset prices rise very fast, as happened after 2000 (i.e. Sudden Debt). Earned income then has no chance to catch up to debt in an orderly fashion and the result is debt default and destruction, with a commensurate plunge in asset prices. That's exactly what is going on right now, of course.

Let's look at this relationship more closely. Below is a chart indexing home prices (Case-Shiller National Home Index), share prices (S&P 500), average hourly wages and household debt per working person. Obviously, assets and debt got way out of balance against income, particularly about 10 years ago.

Notice how asset prices have now corrected to a significant degree, but household debt still remains high. That's because the Fed and Treasury are furiously pumping in public debt into banks' balance sheets to avert (and mask) household debt defaults. But this is a fool's errand: in the end all debts, private and public, must be serviced out of earned income. And since income is extremely unlikely to rise suddenly, debt must also come down, sooner or later.

A few months ago this blog's masthead used to proclaim: "We hold this truth to be self-evident: We cannot solve a debt crisis by issuing more debt". By definition, therefore, the only way to resolve this crisis is to allow debt to be destroyed in as orderly a fashion as possible, taking as long as possible in order to avert social consequences.

My view, thus, is that we are in for a long period of persistent asset/debt deflation that will eventually bring debts and asset prices into closer balance with incomes. At least that should be the aim of our policy makers. But, truth be told, I am not sure at all that they see things this way...

42 comments:

The issue is: how do the several existing powers perceive this crisis and how will they interact among themselves?

I think there is a massive attempt to maintain the status quo. But the the status quo is unmaintainable (at least for those who believe that growth is unsustainable).

One of the reasons for maintaining the status quo is that it is of the interest of people who have a tight grip on power (e.g., banksters). Call it class-warfare if you want.

But another (coming from well intended people, who care for the public good) is just wrong analysis: I was shocked with todays Bob Reich post. People are still completely hooked to the permagrowth way of thought. Bob should know better.

Great analysis, Hell. The problem is that things haven't gotten bad enough to change; i.e., there are plenty of decision-makers who believe that we can go back to the "good old days" of five to ten years ago if we just do some tinkering around the edges and get people to believe again. Their efforts are being undermined by those that know the end is inevitable and are looking for ways to shelter themselves from the storm--I suppose there are those who are doing the former in public and the latter in private.

The shame of it all is that nothing really bad has happened yet--if we would take some pain now it would soften the blow down the road.

Hell - Is there an "easier" way out of all this? Create inflation which creates wage growth - while the nominal cost of fixed rate debt stays the same? If as a whole the American consumer is over levered the politically palatable solution seems like inflation (money printing). I am obviously appalled by this, but I don't really have a vote. As a country, we like easy solutions - seems like inflation rather than debt reduction from restructuring is the easier of the two.

@Hell re: "the only way to resolve this crisis is to allow debt to be destroyed in as orderly a fashion as possible, taking as long as possible in order to avert social consequences"

Not to defend the people in power one bit, but isn't the key word in your posting today orderly?

At least key if you want to look at this from our leaders point of view?

Our brains' do have flawed heuristics when it comes to investment behavior. Our brains are irrational at times.

Work in prospect theory has shown people feel more than twice as much pain from a $100 loss (or the potential of a $100 loss), than pleasure from a $100 gain (or the potential gain).

All this debt is going to be destroyed one way or another but a massive debt destruction via deflationary credit crunch might not be nearly as orderly as the very same process via inflationary credit crunch.

Order is our leaders primary job.

I understand that if you are the skin of an organism that is in shock with hypotension, you are not going to be all that happy that the brain told the circulatory system to shunt blood away from you to other core organs. But the point is to keep the organism whole in the end.

I certainly do not buy into the hyperinflation. The 1970s scenario is enough for me.

Except for a few bad memories and nurturing the neocon ideology, Volcker did it.

However may I ask why the current government that is unable to tighten budget or monetary policy, at least one of the two items, would be able to do it within 10 years. Doe Obama really want to wait for all baby-boomers to have quit work to start the painful payback efforts! That cast some doubts on the payment.

What prevents the administration to tighten now? Are they really expecting some kind of miraculous better times to do so? What better times ? The end of current wars is an acceptable answer. But who has anything like a decent agenda on this.

I recently re-read Rueff, a French economist than most of us here ignore in spite of his brilliant successes. Not as academic but via effective policy-making.

Rueff is adamant on the fact that fiscal policies are the key to balanced external accounts. In view of the aggregate level of debts, balanced public accounts, at all levels, should become a top priority. Not a simple temporary outcome of the current deflationary burst.

I have the feeling that the "fiscal expectations" are currently extremely low in the US. I am under the impression as well that there is a perception that balanced public budgets are deemed illegitimate. Am I wrong?

Combined with massive spending, this is certainly enough to trigger something that could approach hyperinflation. The countries that went this way were decent ones. Even the Weimar was a decent regime held by very decent gentlemen. But the payments for reparations for France and Belgium were deemed illegitimate. No way that the German people would accept to pay anything like reparations. No way to get it to accept anything like a tax-based pay-back.

On the one hand, would could believe inflation could reach Weimar level? But on the other one, in view of the current political climate, I find no possible positive outcome to the current situation. What am I missing?

Jacques Rueff was a genious, not only because he was a great economist, but also because he wrote about small events that had big effects to deepen the depression of the 1930's (you know, the butterfly effect).

However my post is not about Rueff but about raising wages. It is about the Grenelle agreements negotiated in Paris at end of May 1968.

These agreements show that apparently all it needs to raise wages is a little bit of political will. Do our leaders have some of it?

Granted these 10% immediate increases of real wages were negotiated after 4 weeks of strikes and riots, and the only alternative for General de Gaulle who had disappeared during 3 days in Germany would have been to launch tanks into Paris. Fortunately he was a democrat and he never gave that order.

Now guess what: France is still here today, even after these "cataclysmic" wage increases. Strange isn't it?

Even stranger, this episode seems to be forgotten by everyone even here, as I never heard of this through the press or politicians, but thanks to wikipedia!

And an anecdote about these events. The strikes and the riots suddenly ended at beginning of June 1968 after the army filled in the gasoline pump stations tanks which were empty for weeks at that date. This was told to me by my father. I also guess that the weather was fine, but I do not remember the details because I was aged only 5....

"Hell - Is there an "easier" way out of all this? Create inflation which creates wage growth - while the nominal cost of fixed rate debt stays the same?"

That's what the Fed is trying - 'lift all prices little bit so that debt feels less burdensome', isn't it?

Here is the problem. When an economy goes out of balance, inflation will push the sectors in the same out of balance manner. For example, last year we had huge oil bubble (oil=140) that finally broke the back of the consumer. See what happened since Dec. Government's attempts to inflate made oil price rise the fastest, and home prices not move at all. There is no way for the government to increase wages, but they can cut taxes. All tax cuts by Obama, however, got nullified by rising cost of oil. Also, Ben's attempt to bring down mortgage rates through purchase of MBS made treasury rates go up - resulting frozen mortgage market.

The government wants inflation, the financial "Wizards" want a new asset class to inflate and wrap "innovative products" around. Two powerful entities that will cooperate to get what they want. Stagflation anyone?

What is there left to inflate? Commodities? Maybe investment in Chinese and Indian domestic consumption and growth to complete the cycle. Scary thought huh kids?

Greenie is right. But it is also a case of steering our economy vs. foreign competitors.

A carbon tax is politically difficult because of ideology but somehow playing with monetary policy is not as difficult.

So if the Fed inflates commodities prices more than income, it will crimp our economy. But it will also cause commodity consumption relative to income to drop and the 900 lb commodity gorilla is oil and most of our oil comes from abroad.

If our oil consumption drops then our balance of payments drop as well AND the there is a strong boost to mostly domestic energy conservation industries (say LED lighting, smart grids, etc...).

I am sure there are a thousand other loops I am missing but my point is these things will work themselves out either way.

The issue for the politicians is really just an issue of confidence and order, e.g. getting people to believe it is not the end of the world while they do work themselves out.

Somehow debt doesn't disappear without repaying or defaulting. I don't see the former happening much so it's going to be mostly the latter.Looks like the people who took the gamble are trying to spread the losses around as much as possible in as many forms as possible instead of taking responsibility and eating it themselves. Savers (I'm talking global here; pension funds, price inflation, meh, you all know) and (future)taxpayers are of course easy targets. They do get unhappy and angry though.What a waste.

"in the end all debts, private and public, must be serviced out of earned income. And since income is extremely unlikely to rise suddenly, debt must also come down, sooner or later."

Not necessarily. The FED could theoretically print enough money to give everybody $1 million and all debts will be paid and we have inflation Weimar style.The first attempts at this are the $8K bonus for first time home buyers. Now they (Dodd & Co.) are talking about expanding this nonsense to $15K for everybody. Cash for clunkers were owners of gas guzzlers get rewarded $4500 in tax dollars. This is the leading edge of pumping money which was created of out thin air (or at minimum could be created out of thin air) into the economy.So far most of the money government spends is borrowed from suckers around the world. Eventually those suckers will either refuse to buy our debt (see Russia & China) or demand higher yields. Higher yields not only sink over extended home debtors but can do the same to governments. Eventually some very unpleasant truth will be forced on the big spenders in Washington. Default or print up the difference. In the end there's no other way out, only those 2 options exist. Knowing how our poiliticians operate they'll opt for printing up the difference. That scenario is still many years out, but at the current rate we might get there sooner than later.

perhaps part of the problem is resulting from globalization that brought about wage stagnation in the developed countries. While wages stagnate, the desire to keep up with the jones persists, and the solution is to increase debt.

Would there be a chance that policy makers can induce wage inflation? Via protectionism perhaps?

Yes they built up consistently during that period on persistent and intense external US deficits. The associated dollar seigneurage triggered both an industrial boom in Europe - thanks America - and a significant part of local inflation.

This inflation remained under control and noone would argue now that the overall effect of the initial Brettons Woods system was not positive.

But the "fiat money as a reserve" system found its limits for the first time then during the 70s. Volcker made the trick. The US industry found a new youth.

But the problem is now up again on a much larger and trickier scale with China and pegging accross Asia to make it worse.

Yes, indeed, the asset deflation that we have seen to date in shares and housing/real estate dwarfs anything that has been created on the inflation front. If the game were called today, deflation would win the deflation/inflation contest in a rout. All this despite the authorities Quantitative Easing (monetization) experiments.

Clearly the QE gambit has failed as long rates, rather than staying low, have instead crept steadily crept, endangering any chance of putting a floor under R.E. which is essential to the banks balance sheets as all those credit derivatives are backed by real estate.

So, what now? Will the authorities, realizing that they are fighting a losing game, what with their attempts at keeping rates low, backfiring, reverse course. NO!

Despite the thesis that folks like Karl Denninger put forward, where yesterday's buying of the 30 year is some sort of harbinger that The Fed is about to reverse course on its QE, sopping up liquidity, and allow liquidation to occur, I would argue that draining liquidity has enormous political consequence that The Fed, namely Ben Bernanke, will not want to face.

To wit:

How do you justify reversing course when you have acknowledged countless times that the present economic downturn is still in force? If one's efforts via QE are literally causing credit to become more expensive anyway, which is deflationary, then why bother to be the bad guy who takes the punch bowl away. Let it be seen that you tried everything you could and that things simply did not work out.

What I am trying to say is deflation is coming because if the Fed continues their QE, rates go higher driving a stake through the stock market, business activity and last but not least R.E.

If the Fed says no more QE let things go we will get the same as the prop is taken away.

Caveat: How do we get hyper-inflation out of this?

We get it because our currency and bond market are shunned as investors realize that the entire nation is becoming California and we have no money to make good on bonded obligations.

The other way our bond market and currency collapse is because of the wild card factor which involves the revelation of massive fraud and manipulation at the highest levels of government.

At that point, when it is discovered, once and for all, that for example, the Fed is doing all sorts of in violation of its mandate...

Sorry for my last post, what with its poor punctuation and various other problems.

The main point is that hyper-inflation could come as a result of a runaway deflation where confidence disintegrates to a critical degree in the nation's ability to raise revenue to pay for its already bonded obligations.

How it happens is that bond markets in all time durations are shunned causing the government to have to engage in pure unsterilized printing operations.

The main point is that hyper-inflation could come as a result of a runaway deflation where confidence disintegrates to a critical degree in the nation's ability to raise revenue to pay for its already bonded obligations.

How it happens is that bond markets in all time durations are shunned causing the government to have to engage in pure unsterilized printing operations.

Austrian economists will argue, along with Von Mises, that once a certain level of debt is reached, only hyperinflation and deflation can occur.

I'll add possibly in sequences. Unmanageable ones. That's in view of their most articulate writings that I'll buy into the above.

Not even paying the time to read again what Greenspan and Bernanke wrote on their so-called "handling" of interest rates.

Why are inconsistent economists with systemic failure as a background the joystick in hand whilst Volcker is left in the background? We all know the answer. The country would not like the cure. But there no other one.

"...the banks’ free reserves at the Fed are just shy of $950 billion. This is off of a base measure of around $8 billion to $10 billion before August 2007. It’s a monster number. The Fed has created an awful lot of potential spending power. The money will show up as inflation when the banks withdraw it through the Fed and make loans, which would trigger the spending. I think the only way of avoiding it would be to pull a nationalization-style trick, not that I’m advocating it, but the Fed does think this way. They could say to the banks, “Remember that $950 billion that you had for your reserves? We’re now converting it into mandatory 10-year Treasuries, and that’s that.”

First off, hyperinflation (in the USA, that is) is not possible short of some massive unforeseen war (that we lose). Weimar style hyperinflation was caused by the fact that Weimar held debt in foreign currencies, not their own. All of our debt is in dollars. Hyperinflation does foreign holders of treasuries no good. What would the dollar inflate with respect to? There is no other reserve currency. Maybe in 50 years something else will crop up, but not right now.

I maintain that the amount of money lost through housing deflation will far offset the amount of money "printed" for the banks. hello deflation. At best, we could have a balance between the two and get a really long lost decade.

On Margin: Theoretically, we could "inflate our way out of it" but in practice, I can't see it working without disastrous consequences. Perhaps if the bond markets were not a global thing...If it became clear that we were taking this road, the bond market would not be happy. Higher interest rates mean we need to issue more debt, which means we need more people to buy (unlikely), which means higher interest rates, which means more debt...you see the problem.

Treasuries are the last bubble. Housing was a HUGE bubble. Treasuries are the only asset class that could possibly "hide" the burst of the housing bubble. Besides, inflating anything else will screw over any type of recovery. Could you imagine what $5/gallon gas would do with 10% unemployment?

Daniel in Paris: I don't think "illegitimate" is the right term. More like a pipe dream. I talk to far too many people who don't understand the basic economics of our budget (what else would you expect from a populous with too much debt?) and none seem to understand the gravity of the situation. We have run a massive defect for so long nobody seems to remember what the government was like and I fear so many services will need to be cut that no politician will have the balls to actually do it until it is too late.

What's the saying? You can count on Americans to do the right thing after exhausting all other options? Sounds about right.

Nate:"Theoretically, we could "inflate our way out of it" but in practice, I can't see it working without disastrous consequences. Perhaps if the bond markets were not a global thing...If it became clear that we were taking this road, the bond market would not be happy. Higher interest rates mean we need to issue more debt, which means we need more people to buy (unlikely), which means higher interest rates, which means more debt...you see the problem"Right. But obviously this is not sustainable. At some point nobody will loan US any more money regardless of the interest rate. Would you loan a junkie $100 even if he promises you to pay you back $200 the next day? Only a fool would and eventually the world will run out of fools.So at that point some very unpleasant decisions will be forced down our throat. Default or monetizing the debt. Those are the only 2 choices once we reach the end of the road we're currently on.

Mark my words. The notion that you can't have a hyper-inflation in a reserve currency is going to be proven to be absolute balderdash. The Chinese are quite prepared to take the hit on their U.S. sovereign debt holdings. To answer the question, The hyper-inflation would occur against anything that is seen as having real instrinsic value, food, land, gold, silver, (don't laugh) objet d'art.

This is a confidence game my friends. And when, not if, that goes for good, it means that there will be far too few lenders to allow us to escape Weimarization.

You see, Obama was too weak to break the bankster-oligarchs; having shown this to the world, he will not have more luck with the medical-insurance cronies!!

Having failed yet again, Obama - to show the world that he is not a complete pussy (and divert attention away from the total lack of performance on USD-paper, including the USD itself) - he will run off and bomb someone like maybe North Korea ...

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Although the statement - you can't get out of debt by creating more debt makes sense on the surface you have to realise that there are two types of debts - debts that your or I owe, debts that sovereign nations owe in their own currency.

For nations the idea of debt is simply an accounting nicety. If the US debt holders ever require interest or principal repayment, the US can simply electionically credit the required bank accounts. US Dollars being no more than digits in a computer system.

I just found this post and it seems to define the problem very succinctly. It would seem to me that the most orderly way to retire debt would be for the Federal Reserve to loan the Federal Government money and then simply forgive the debt over time. So we can absorb the debt into some level of inflation.

About Me

I was educated as a chemical engineer but spent almost my entire career in finance, particularly in money, FX and bond markets. The name stands for Hell-as-IOUs and the picture points to Quixotic endeavors.